Regarding interest rate policy, although further reductions from the current federal funds rate target of 1 percent are certainly feasible, at this point the scope for using conventional interest rate policies to support the economy is obviously limited.  Indeed, the actual federal funds rate has been trading consistently below the Committee's 1 percent target in recent weeks, reflecting the large quantity of reserves that our lending activities have put into the system. In principle, our ability to pay interest on excess reserves at a rate equal to the funds rate target, as we have been doing, should keep the actual rate near the target, because banks should have no incentive to lend overnight funds at a rate lower than what they can receive from the Federal Reserve. In practice, however, several factors have served to depress the market rate below the target. One such factor is the presence in the market of large suppliers of funds, notably the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, which are not eligible to receive interest on reserves and are thus willing to lend overnight federal funds at rates below the target.¹ We will continue to explore ways to keep the effective federal funds rate closer to the target.

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1.  Banks have an incentive to borrow from the GSEs and then redeposit the funds at the Federal Reserve; as a result, banks earn a sure profit equal to the difference between the rate they pay the GSEs and the rate they receive on excess reserves. However, thus far, this type of arbitrage has not been occurring on a sufficient scale, perhaps because banks have not yet fully adjusted their reserve-management practices to take advantage of this opportunity.

The efforts by central banks around the world to increase the availability of liquidity, along with other steps taken by central banks and governments, have contributed to tentative improvements in credit market functioning. However, the continuing volatility of markets and recent indicators of economic performance confirm that challenges remain. For this reason, policymakers will remain in close contact, monitor developments closely, and stand ready to take additional steps should conditions warrant.

Many analysts expect the U.S. economy to regain positive momentum sometime in 2009. That strikes me as a reasonable expectation, for several reasons. First, monetary policy is now quite stimulative. The federal funds target rate is 1 percent, below the expected rate of inflation. Second, the major shocks that dampened economic activity this past year have already subsided or are in the process of doing so. Energy prices, thankfully, have reversed most of the earlier run-up; that will free up a portion of consumer budgets for spending on other goods and services. And as I've mentioned, the drag from housing seems likely to lessen in the next year, and in fact, I would be surprised if we don't see a bottom in housing construction around the middle of 2009. This is the third straight year, however, that I've been expecting a bottom in the housing market in the middle of next year, so my outlook is tempered by more than the usual amount of humility.
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The sharp decline in oil prices since they peaked this summer has flattened the overall inflation rate in August and September. Many economists are forecasting a decline in core inflation as well in the months ahead, on the grounds that widening economic slack is generally associated with declining price pressures. While this correlation is detectable in many datasets, I would be cautious about relying on it as a causal relationship.⁴ In particular, this relationship can shift over time as expectations about the conduct of monetary policy evolve. Those expectations will be influenced importantly by the measure of monetary stimulus provided during the downturn and how long that stimulus remains in place. As a recovery begins, the path of least resistance is often to hold the policy rate at a low level until it is completely clear that recuperation is complete. The risk associated with that path is that inflation may not moderate obediently during the downturn, and may firm with the ensuing recovery. It is crucial that we not allow expectations of future inflation to ratchet higher during this recession.

Over the past year or so, the FOMC has cut its federal funds rate target by 425 basis points to its current level of 1 percent.  Nonetheless, most private-sector borrowing rates are higher now than at the beginning of this crisis in August 2007. In pointing this out, I don’t mean to imply that the rate cuts did no good: borrowing rates in my view would be substantially higher absent the reduction in our base lending rate. It’s just that the effects of the growing credit crunch have outpaced the easing of policy, and, indeed, every major sector of the economy has been adversely affected by it.

Federal Reserve Bank of San Francisco President Janet Yellen said the central bank may cut the benchmark interest rate close to zero percent from the current 1 percent level should the economy remain weak.

``We would do it because we are concerned about weakness in the economy,'' Yellen said today after a speech, responding to an audience question about the impact on the economy should the Fed reduce the main rate to as low as zero. ``I think we could, potentially, go a little bit lower than'' 1 percent, she said in Berkeley, California.

From audience Q&A, as reported by Bloomberg News

Core inflation for personal consumption expenditures was up to 2.6 percent (year-over-year) in August. In my opinion, this rate has been high...Although some risks to the inflation outlook remain, a forward-looking assessment would put less weight on inflation concerns than earlier this summer.
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The outlook for real economic activity likely will result in production, spending, and labor markets being very sluggish in the second half of this year and well into 2009. I expect that such activity will then pick up as the housing and financial markets gain headway in working through their problems. Such progress would be signaled by stabilization in construction and improvement in credit flows.
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There is, of course, a level of cloudiness in any economic forecast. In the current situation, the substantial stress in the financial markets has led to an unusually high degree of uncertainty. This is because it is extremely difficult to assess how the turmoil will influence markets and how policy responses to address the economic unrest will play out over time...We at the Federal Reserve continuously reevaluate the stance of monetary policy in light of current and forecasted conditions, as well as our assessments of the risks to our long-term objectives of maximum sustainable growth and price stability. Currently, these risk assessments must factor in the substantial uncertainties in the outlooks for growth and inflation that I just described. These uncertainties certainly pose difficult challenges for policymakers.

      "The Fed was very aggressive in the first part of 2008 in reducing interest rates,'' Bullard said during a panel discussion today at Washington University in St. Louis. ``That was taken very much preemptively,'' and ``with the idea that we might be in the situation that we're in right now.'' 

     The central bank's Federal Open Market Committee lowered the benchmark rate four times in January to April. Bullard said ``the wisdom of that is showing up now,'' as the economy falters and credit crunch deepens.

As reported by Bloomberg News

Given the likely drawn-out nature of the prospective adjustments in housing and financial markets, I see the most probable scenario as one in which the performance of the economy remains subpar well into next year and then gradually improves in late 2009 and 2010. As credit restraint abates, the low level of policy interest rates will begin to show through into more accommodative financial conditions. This improvement in financial conditions, together with the gradual stabilization of housing markets and the stimulative effects of lower oil and commodity prices, should lead to a pickup in jobs and income, contributing to a broad recovery in the U.S. economy.

At the same time, inflation seems likely to move onto a downward track. If sustained, the recent declines in commodity prices should soon lead to a sharp reduction in headline inflation. In addition, I expect core inflation to slow from current levels as lower commodity prices and greater economic slack moderate upward pressures on costs. Similar reductions in inflation abroad, as well as the recent appreciation of the dollar, should restrain increases in the prices of imported goods.

I would caution, however, that the uncertainty around my forecast is substantial. The path of the economy will depend critically on how quickly the current stresses in financial markets abate. But these events have few if any precedents, and thus we can have even less confidence than usual in our economic forecasts.

Our strategy will continue to evolve and be refined as we adapt to new developments and the inevitable setbacks. But we will not stand down until we have achieved our goals of repairing and reforming our financial system and restoring prosperity.

Recent financial developments and economic data make it clear that the outlook for the U.S. economy has weakened noticeably, and inflationary pressures have substantially abated. Coordinated action symbolizes the determination of central banks to act together to address what is now a global crisis. And it diminishes the potential exchange rate repercussions of any single country’s solo action.

We will not stand down until we have achieved our goals of repairing and reforming our financial system and thereby restoring prosperity to our economy...I strongly believe that the application of these tools {the response by policymakers}, together with the underlying vitality and resilience of the American economy, will help to restore confidence to our financial system and place our economy back on a path to vigorous, healthy growth.

Overall, the combination of the incoming data and recent financial developments suggests that the outlook for economic growth has worsened and that the downside risks to growth have increased. At the same time, the outlook for inflation has improved somewhat, though it remains uncertain. In light of these developments, the Federal Reserve will need to consider whether the current stance of policy remains appropriate.

A key concern is that the current level of the federal funds target rate, at 2 percent, is well below the current rate of overall inflation. This means that the real cost of borrowing short-term is negative. In other words, the FOMC’s interest rate target is unusually low. Over time we will need to adjust this rate to a level that is more conducive to long-run price stability and maximum sustainable employment.
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The near-term outlook for economic growth and inflation is above all uncertain. Two keys to future economic performance will be stabilization in housing and financial markets. Financial market turmoil has recently been severe, and the consequences of this turmoil on real economic performance entail clear downside risk. If financial market turmoil can be contained, the FOMC can turn attention to achieving better inflation results than those recently experienced. Until inflation clearly moderates, my colleagues and I will need to be especially watchful that our accommodative policy stance does not begin to worsen the outlook for long-run price stability.

Real gross domestic product is likely to expand at a pace appreciably below its potential rate in the second half of this year and then to gradually pick up as financial markets return to more-normal functioning and the housing contraction runs its course.  Given the extraordinary circumstances, greater-than-normal uncertainty surrounds any forecast of the pace of activity.  In particular, the intensification of financial stress in recent weeks, which will make lenders still more cautious about extending credit to households and business, could prove a significant further drag on growth.  The downside risks to the outlook thus remain a significant concern.
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If not reversed, these developments {the retreat in energy prices}, together with a pace of growth that is likely to fall short of potential for a time, should lead inflation to moderate later this year and next year.  Nevertheless, the inflation outlook remains highly uncertain.  Indeed, the fluctuations in oil prices in the past few days illustrate the difficulty of predicting the future course of commodity prices.  Consequently, the upside risks to inflation remain a significant concern as well.

Although this rate is low by historical standards, I still don't consider the stance of monetary policy to be excessively stimulatory. In light of all of the disruptions to the financial system I described, I consider financial conditions to be more restrictive overall now than when the financial crisis struck a year ago. Policy must be calibrated to push through the substantial headwinds the economy faces.